LESSON III

DEMAND ANALYSIS

Demand is defined as, the amount of a commodity people are willing and able to buy at all
possible prices and in a given time.

There is a difference between demand and wants, in that demand are human desires that are
fully backed by the ability to pay. On the other hand, wants are human needs that are not
backed by ability to pay.

FACTORS THAT INFLUENCE QUALTITY DEMANDED

 Price of the commodity itself

 Price of other commodities which are related to the good in question (be they substitute
or complementary) (Py)
 Consumer income (y)
 Consumer taste and preference for the good (T)
 Advertisement(A)
 Consumer expectation about future prices (E)
 Size of population and its composition (N)
 Credit availability (C )
 Other factors (Z)
Using a functional notation we come up with the following demand function

Dx
 
f px , p , y,T, A, E, N,C, Z ......................... 1
This simply states that the individual demand for good X is a function of all the factors listed
in the brackets.

i) The price of the commodity itself

In order to analyze the effects of price on quantity demanded of the commodity, we
hold all other factors fixed. the relationship between price and demand can be
explained by the help of the law of demand. According to Alfred Marshall this law is
defined as, “other things being equal, with a fall in price, the demand for the
commodity is extended (increases), and with a rise in the price, the demand is
contracted (decreased)”

This law can be explained with the help of a demand schedule and curve.

Demand Schedule: is a tabular representation of the quantity demand of a good at

given price level and at a given point in time.

Demand curve on the other hand is a graphical representation of the content of the
demand schedule.

17
 Demand schedule

Price in Kshs Quantity demanded

25 1
20 2
15 3
10 5
5 7

From this demand schedule, a demand curve can be plotted as shown below.

Price

25
20 *
Demand curve
15 *
10 *
5 *
*
012 34 7
Quantity
56 Demanded

18
 In the above diagram it is seen that the demand curve slopes downwards from left to
right showing that at higher prices less is demanded and at low prices more is
demanded. We can thus say that for normal demand curve, less is demanded at
higher prices and more is demanded at low prices.

REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE.

i) Inverse relationship between price and quantity demanded of a normal good according

to the law of demand

ii) Lowering prices brings in new buyers who were not able to buy at the previous price.
iii) Reduction of price may coax out some extra purchases by each of the initial
consumers of the goods, while a rise in price may lead to less purchases. Naturally,
consumers will try to substitute the commodity with another cheaper one.
Note also that a fall in price implies a rise in real income, hence the ability to
purchase more of the same good.

iv) Whenever a commodity becomes expensive its consumption normally will be left for
only very important uses. For instance a consumer may opt to use electricity lighting
only, and not for cooking if its prices sky rocket. The vice versa is also true.
EXCEPTION TO THE LAW OF DEMAND

There exists cause where demand may slope upwards instead of downwards from left to
right.

(i) In the case of Giffen goods:- Giffen goods (named after the economist Sir Robert
Giffen) are very inferior goods for which demand increase as price rises and decrease
as price falls. This applies to poor communities.. e.g. In Asia people’s stable food is
rice. If price of rice was to fall, consumers may reduce their demand for rice or
consume the same amount of rice and use their extra money saved as a result of fall in
price to purchase some more nutritional food. If price increase of rice, then they
would only consume the rice.
10
 Q
p  0

(ii) Veblen good (goods of ostentation)

Goods associated with the rich, luxury goods such as jewellery, luxurious vehicles etc.
the value of such goods (quality) is measured by how much expensive it is. For such
goods, the higher the price, the higher will be the demand.

Q
p  0

(iii) Fear of future rise in price

fear of future rise in price makes consumers buy more quantities of different goods
even at higher prices than before because they know that if they dont buy more now,
they will have to pay much higher prices in future.

The existence of such goods and factors explain why under exceptional case the
demand curve may be positively sloped as below.

iv) Necessities

Necessities like medicine have to be consumed even at very high prices since people
have to consume such commodities for survival.

v) Habit Forming Commodities such as alcohol and cigarette smoking

vi) Ignorance of prices i.e one can be consuming a commodity at high prices due to
1.1 SUBTOPIC
ignorance of prices in the1market.

20
The existence of such goods and factors explain why under exceptional case the demand
curve may be positively sloped as below.

Price of
commodity

D Demand Curve for

0 Quantity

21
CONCEPT OF MOVEMENT ALONG DEMAND CURVE AND SHIFT OF DEMAND
CURVE.

A movement along a given demand curve is caused by change in the price of the
commodity. Its also referred to as change in quantity demanded. An upwards movement
is caused by an increase in prices while a downwards movement is caused by a fall in prices.
This can be shown as below.
Price of

p2 a

p1 b
D

0 Q1 Q2 Quantity

A movement from b to a is caused by a (rise) change in price prom p to p and a

1 2

movement form a to b is caused by a fall in prices

from p2 to p1 .

Note: as price falls p2 to p1 , quantity demanded rises from Q1 to Q2 .

from

A shift of the demand curve is caused by change in other factors influencing demand
other than price of the commodity. Its also referred to as change in demand. The impact
of these other factors shall be observed later.
 A shift of the demand curve can either be to the right or left depending on the direction on
which a change has taken place. A shift to the right shows an increase in demand while a
shift to the left shows a decline in demand.

Price of

Increase
Decrease
D1
D
D2
0 Quantity

In the diagram above

D1 represents an increase in demand while D2 D2 represents a
decline in demand. D1

23
 OTHER FACTORS THAT INFLUENCE DEMAND

2) price of other commodities which are related to the good in question:

There are two possible relations between the demand of one commodity and the price of
other commodity.

i) substitutes

A increase in price of one commodity (X) leads the increase quantity demanded of
good Y, the two commodities x and y, are said to be substitutes.

When prices of one commodity fall, the household buys more of it and less of
commodities that are substitutes for it.

Example:

a. Butter and Margarine

b. Sukuma wiki and Cabbage
c. Beef and Fish
ii) complements
If an increase in price of one commodity reduces the quantity demanded of another
commodity the two are said to be complements.

When the price of one commodity falls, more of it is consumed and more of those
commodities that are complementary to it are consumed also. Example, motor cars and
petrol, butter and bread etc.

24
 Price of Price of

p0 p0

p1 p1

Q1 Q0 Quantity Q0 Quantity

i Q1

ii 

Graph 1: curve sloped upwards indicating that as price of a substitute falls, the quantity
demanded of good x falls. So good y, and x, are substitutes.

Graph 2: curve slopes downwards, indicating that when the price of a complement falls there
is a rise in the quantity of good x demanded.

3) Consumer income
We would expect a rise in income to be associated with a rise in the quantity of a good
demanded. Goods obeying this rule are called normal goods. In some cases a change in
income might leave the quantity demanded completely unaffected. This will be the case
with goods for which desire is completely satisfied after a level of income is obtained.

25
Example: if one used to eat salt, the consumption of it will not change even though his
income rises, unless his income is very low.

Incase of other commodities, rise of income beyond a certain level may lead to a fall in
the quantity that the household demand. If the demand for a commodity falls as income
rises, the good is called inferior good.

The relation between income and quantity demanded can be shown by the use of Engels
curve

Income Y

0 Quantity

The curve shows the relationship between income and demand, holding other factors
constant. Engel curve for normal good slopes upwards, implying that as income rises,
quantity demanded will also increase. Incase of inferior good, if Y increases Q decreases.
In this case the Engels curve will slope downwards from left to right.

26
 DISTINCTION BETWEEN GIFFEN GOOD AND INFERIOR GOOD

Giffen good; relates to behavior of quantity demanded in relation to price.

Inferior good: relates to behavior of quantity demanded in relation to income.

4) Consumers tastes and preferences

When the tastes for a commodity are favorable, consumers will prefer more of that
commodity to other commodities thereby increasing the demand for the commodity.

For example, in the beauty, would the taste of women have moved towards colored hair
products such as pony tail or dyeing of hair. So the demand of such products would hike.

5) Advertisement:
As a producer advertises his product, he creates awareness that his products exist, and he
tries to show the superiority of his product over others in the market. If we hold other
factors constant, we expect that an increase in advertisement expenditure will lead to an
increase in demand.

Advertising is

 Informative
 Persuasive on price, availability, performance.

27
 6) Consumers expectations about future prices:
If consumers expect the price of a commodity to rise in future, they will buy more of the
commodity now and store it. In this case quantity demanded increases. However, should
they expect a fall in price in future they will buy less on the commodity now hoping to
buy more in future after the price has fallen. In this case quantity demanded becomes
less.

7) The size of population and its composition.

The greater the size of population to satisfy, the greater the quantity consumers will be
willing to demand. The fewer the consumer in the market, the less the quantity demanded
will be.

When we talk of composition of population we are talking of the sex proportion and age
group. Certain commodities are manufactured for certain age group and sex. For instance,
cosmetics are meant to be used by women, napkins by infants, shaving cream by men. So
producers consider these factors before deciding how much to produce. Who shall be his
target market?

ELASTICITY OF DEMAND
Elasticity of demand is the responsiveness of the quantity demanded due to a change in any of
the factors influencing demand.

DISTINCTION BETWEEN POINT ELASTICITY AND ARC ELASTICITY OF DEMAND.

The two are different ways of computing elasticity of demand.

1. Point elasticity
Point elasticity is the proportionate change in quantity demanded resulting from a
proportionate change in price at a particular point along the demand curve.

When calculating point elasticity, it is assumed that the slope of the demand function
is known.
28
From the formula for elasticity,

𝑙 pp 
Q p
p Q

As noted earlier
Q is the reciprocal of the slope of the demand function.

p

Given a demand function Q  b0  b1 p.

Q
is found by getting first derivative of Q with respect to p
p

p
Thus point of elasticity 𝑙 pp  b 
1
Q

9
Example

Demand schedule

Price Quantity

0 40
1 35
2 30
3 25
4 20
5 15
6 10
7 5
8 0

Price

a
6
p
slope  8
 40
4 b
Q

D
0 10 Quantity
40
20

1
0
Arc Elasticity

Arc elasticity is a measure of the average elasticity; i.e. the elasticity at the mid point of the chord that
connects 2 points (A and B) along the demand curve defined by the initial and the new price levels.

Price

A
p1

B
D

0 Q1 Quantity
Q2

1
1
Using example in above demand schedule.

Assume initial price

p1  5 , which then increases p1  6
to

p1 Q1
5 15

p2 Q2
6 10

Q  Q2  Q1  10 15  5
p  p2  p1  6  5  1

p1  p2  11
Q1  Q2  25
5  11  1
E    2
p  
1 25 5
 

1
2
Income Elasticity of Demand

This can be defined as the responsiveness of quantity demanded to change in income in %

term it can be defined as:

% change in quantity demanded

EY 
% change in Income

So that EI
Q Y
 Y Q

Where

Q is change in quantity demanded.

Q is original quantity demanded.

Y is change in income

Y is original income.

Arc income elasticity of demand can be calculated as:

Q
E 
  Y1  Y2 
Y
 Q1  Q2 
Y

1
3
 Income elasticity of demand for most commodities is positive, indicating higher
purchases at higher income. Income elasticity for a few commodities is known as inferior
goods.
 Degree of income elasticity varies in accordance with the nature of commodities
consumers consume in general. Where the commodity id a basic necessity, the demand is
not very responsive to change in income. Basic necessities like food are usually bought in
fairly constant amount and on regular basis. In this EY  1
case
 However, in the case of luxuries, the demand is very responsive to change in income.
Sales of such goods increase rapidly with increase in income. In this case EY  1

Cross elasticity of Demand

 The demand for one product can be influenced by the demand. For example, the demand
for good product depends on the demand for pork, mutton and fish etc. if the price of beef
rises while prices of substitutes (pork, mutton and fish) remains unchanged, consumers
will substitute beef with the cheaper product.
 In some cases, an increase in price of one product can lead to s reduction in demand for
other products. This is true of complementary products e.g. electricity and electronic
gadget, petrol to automobile etc. in this case the products are considered to be
complementary or used together rather the substitutes.
 Therefore, cross elasticity is the percentage change in quantity demanded of good x due
to 1 % change in the price of good Y it measures the degree of responsiveness of demand
for one product to changes of the price of its substitutes or complementary goods
 For instance, cross elasticity of demand for tea (T) is the percentage change in its quantity
demanded with respect to one (1) percent change in price of its substitute coffee (C).

1
4
 Point cross elasticity is calculated by the formula

Et ,c 
QT pc
pc QT

Where

pC is price of coffee

QT is quantity of tea.

Cross elasticity of demand can either be positive or negative.

 A high positive cross elasticity means that the commodities are cross substitutes. If price of
butter increases, the price of its substitutes (margarine) held constant, the quantity demanded of
margarines would increase.
 A negative cross elasticity means that the goods are complementary in the market, thus a
decrease in the price of one stimulates the sale of the other.
 A cross elasticity of zero means that the goods are independent of each other in the market.

1
5
Numerical example

QY  5000  0.5 pY  2.3pW  0.2 pX  0.000001pZ  0.0037I

Compute different price elasticity and state the relationships between the commodities Y, W, X and
Z.

Solution

Take first derivative of commodity Y with respect to all other products.

Q
Y  0.3
p Q
Y
 0.2
W

Q  pX
Y 0.000001
pZ

pW pX pZ
We know with certainty that the ratios , and are all
QY QY QY
Qy pw
positive. pw   0.3 From this example it is clear that good y and w are
E
Y ,W
pw Qy Qy
Qy px
complementary goods since is negative. px   0.3
E E
y,w y,x
px Qy Qy

E y, x , is positive implying that x and y are substitutes. Good z and y are independent and

1
6
DETERMINANTS OF PRICE-ELASTICITY OF DEMAND

The following are the main determinants of price elasticity of demand.

 Availability of close substitutes to the commodity.

 Nature of a commodity
 Proportion of income which consumers spend on a particular commodity.
 Range of uses of a commodity.
 Habits
1. Availabity of close substitutes-The higher the degree of the closeness of the substitutes,
the greater the elasticity of demand of the good or service. For instance, coffee and tea
may be considered as close substitute for each other. Therefore, 1 percent increase in
price of say coffee, would lead to more than proportionate decline in quantity demanded
of coffee.
2. Nature of a commodity-Demand for luxury goods (e.g. refrigerator, TV etc) is
more elastic because their consumption can be dispersed with or postponed when their
prices rise.On the other hand, consumption of necessities (e.g. foodstuffs), essential for
life, cannot be postponed and so their demand is inelastic.
3. Proportion of income which consumers spend on a particular commodity-If
proportion of income spent on a commodity is large, its demand will be more elastic, and
vice versa. A classic example of such commodities is salt, which claims a very small
proportion of income whereas clothes, and other durable consumer goods claim a large
proportion of income.
4. Range of uses of a commodity- The wider the range of uses of a product , the higher the
elasticity of demand. As the price of a multi-use commodity decreases, people extend
their consumption to its other uses, thereby increasing the demand. For instance, milk can
be taken as it is, it may be converted into cheese, ghee and butter. The demand for milk
will therefore be highly elastic

1
7
Habit: some goods are consumed because of habit e.g. smoking, in this case
we find that price changes leave quantity demanded more or less unaffected.
In this case their demand is said to inelastic.

1
8